Monday, September 12, 2016

Albany International: a work program for a fund manager

This is going to be a stock note with a difference - because it is not a stock note. But it is about a stock/business - Albany International is a company that makes machine cloth based in upstate New York. The interesting part of Albany though is that it has a high-growth but unprofitable aerospace business.

The note however was an early work program to decide whether we wanted either

(a) no position,
(b) a small position,
(c) a large position.

The original note was a little rough - as it was an internal work program. And it involved a New York based investor who helped me with the leg-work in upstate New York. (As I do not have their permission I have not revealed either their names or the results of their work).

So I have tidied this note up a little and removed names since the original. But the note is accurate as to what we did and how we approached it.

If you wonder what a good fund manager really does this is a decent illustration. (I wish our work were always of this standard. It is a hard standard to maintain but I will try.)

For the record we settled on a small position. We were not entirely thrilled with the outcome of our research - but I am not going to tell you how we got to that conclusion. Rather I will leave the leg-work for you.

The work program was stated in a letter to my staff member (Luke) and my generalist New York friend.

Below is an edited version of that letter.

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Fan Blades, machine clothing and Albany International

This is a project that I want to do as a joint project with James (name changed). So let’s start with an introduction –

James is a friend of mine from New York. He used to be senior at XXX (which is a way-more-than-average sophisticated fund manager). He probably has some pretty good New York connections and staff to help us do the checking there.

Luke is fairly new to funds management but has a PhD in physics – and has lots of experience as a high-end physicist/engineer – mostly in thin films. Luke is more than capable of checking any of the science that I am asserting. And I would like to be checked.

The market cap is just under $1.3 billion and they are based in upstate New York.

I was hoping James could do any New York style leg-work (scuttlebutt in upstate New York and finding out what we can about the Rochester plant described below) and Luke can check we are not bullshitting ourselves on the science.

The end margin of the aerospace business (described below) is also completely unknown. (I will guess – but it is a guess…)

Background

Albany is a high-tech weaving company whose main business (where it is the world leader) is machine cloth. Machine cloth is the fabric that goes around paper plants and the paper is rolled between rollers and machine cloth.

Machine cloth naturally a pretty good business because better machine cloth makes better paper, plants get optimized making switching hard. Moreover machine cloth is a consumable and is not hugely vulnerable to the paper capital equipment cycle. There are a fair few competitors – most notably the paper making OEMs – but machine cloth seems to have sustainably high margins.

However the paper industry is in decline – especially the higher grades of paper which is where Albany has some position. So machine cloth is a good business in decline.

The company explicitly says that their job is run this business at as slow a decline as possible.

Albany International had lots of other businesses in the past – but they sold them all to focus on machine cloth and aerospace. They have purchased some aerospace businesses.

The original aerospace business comes from weaving carbon fibers. In the carbon fiber business there are a few dominant fiber providers (Toray in Japan, Hexcel in Stamford for aerospace carbon fiber) and there are a few resin companies (eg Hercules).

The carbon fiber fabrics are mostly made by formerly high-tech fabric makers. Indeed almost all carbon fiber weaving companies started at the technical end of fabric manufacture.

This is also the origin of Albany's aerospace business. The position Albany have in aerospace looks potentially good – but there is almost no revenue now (about $100m at a loss).

They are guiding towards $450 million in revenue in a few years.

If this revenue is at fat margin (likely but unknown) and the machine cloth business does not go away (also likely but unknown) then this should be a good stock.

Machine Cloth

First – I have verified externally absolutely nothing in this machine clothing business. (All my work has been on verification of the aerospace business). If anyone knows any way of verifying this stuff – for example has contacts in the paper industry – I would love verification. ("Trust but verify” is a good slogan.)

Company presentations give EBITDA margins in the high 20 percent range.

The presentations however focus on EBITDA. Alas anyone who knows about technical looms will know that it is a relentlessly capital intensive business (witness all the wining that Warren Buffett did in early Berkshire letters about the mess that the textile company was).

So lets pull the EBIT numbers rather than EBITDA –

But $140m in income on $655m of sales is not unattractive… its still greater than a 20% margin business. Alas this is before a disconcerting large amount of "corporate expenses and other". If all the corporate expenses are loaded on the machine cloth business (likely unfair) the margin winds up (pre-tax) at something like 10 percent. This is consistent with the GAAP accounts.

That said - I know little about the machine clothing business and verification would be nice.

The Aerospace business

The appeal of the stock however is the aerospace business and not the declining machine cloth business. The short-explanation can be found here…

LAMINATED COMPOSITES, USED IN EVERYTHING FROM THE skins of fighter planes to golf-club shafts, have one big flaw: They tend to come apart when the resin holding their layers together cracks under stress. Borrowing from the ancient art of braiding, Albany International Corp. in Albany, N.Y., has come up with a way to make laminated composites stronger. It's common to braid layers of a composite separately, but Albany International goes further by braiding each layer to adjoining ones. Anchored together, they can't slide past one another like cards in a deck--the leading cause of cracking in laminate resins.

The company's Multilayer Interlock Braid technology is starting to find applications, according to the inventor, David S. Brookstein, who remains a consultant to Albany International after becoming dean of the School of Textiles & Materials Technology at Philadelphia College of Textiles & Science. The U.S. Army has used some of the prototype material to build inflatable arches for a portable hangar. And Brookstein says the company hopes to work with a large medical-device company to adapt the process to make a hip implant whose stiffness could be customized.

The company has been making fairly bold claims though… this is also from a slide in (what was) the last presentation…

Note an “objective” of $450 million in revenue by 2020. (Is an “objective” lesser than an “expectation”?) And is the “assuming no new business” an indication that the revenue might be higher?

That said they have existing contracts including most importantly making fan blades for the LEAP engine.

LEAP is the successor engine to GE/SAFRAN’s engine for the narrow-body market (ie 737 and A320s). Note that GE current engines have a 65 percent share in that market but a lower share in the forward order book – so it is not as good as it looks. (The old one was the biggest selling and most profitable jet engine of all time…)

Here is the projection of LEAP revenue.

And there are a bunch of other programs that they think get them to 450 million run-rate by 2020.

They show pictures of their production facilities on the presentation – but most of these – as we shall see below – are JVs with SAFRAN. Here is the picture…

If these are real they must be JVs because there is (listed here) 1.2 million square feet of plant (and more under production) and there are only 1250 employees. This is a thousand square foot of plant per employee – which is – as you might observe – spaced out. So what these plants are and how much of them is owned by Albany International needs to be determined.The margin question

I have no idea of the margin for all this aerospace product. That will be the determining question - because if this is fat margin business you want to own the stock. All I have done is some verification of revenue stream – particularly re fan-blades.

We will need to try and get a handle on what the margin will be. (More on this below.) However the way of thinking this is through the history of fan blades - and some discussion on how easy/difficult this project turns out to be.

Fan blades – a potted history

Modern commercial jets are “turbofans”. A turbine drives a fan at the front of the engine – and that fan creates up to 90 percent of the thrust. It also has to be able to withstand bird strike (at horrendous forces) and has to be enclosed by a case which is able to withstand an accident where a fan breaks off. (This is the so-called fan-blade-off test which is the hardest of the FAA mandated safety tests…)

The case and the fan are almost always a unit – and the tolerance between them is extremely fine. The inner surface of the case is usually some abradable material as the tolerances are so fine some abrasion is possible.

When Rolls Royce developed what was the first decent engine capable of carrying a wide-bodied plane (the RB211) they had an agenda of making an engine in which the fan could spin at a different rate to the core of the engine (which is done through multiple spindles) and having a carbon composite fan (made of a carbon fiber product called Hyfil).

They succeeded on the first task - Rolls Royce developed an engine in which parts spin at different rates.

But they failed comprehensively at a reasonable composite fan. The fan shattered when chickens were shot into it at high speed. (Obviously bird-strike is an area.)

So eventually they wound up with a titanium sandwich fan blade. You can see these blades and something of the manufacture in this video.

They key section goes from 12.20 to 17.40. (The rest of the documentary is kind of fun too…)

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GE in JV with SAFRAN has managed to make a composite blade and they use it on their wide-bodied engines…

This is a video released by GE Aviation (apparently to the surprise of the Hexcel who told us that they had been told by GE that much of this is secret). Watch the whole thing – because you will get some idea of the tech.

Note that this is a laminate production process – the starting product is a roll of pre-impregnated carbon fiber. The supplier of that is Hexcel (based in Stamford) and the resin is supplied by Hercules. The Hexcel IR told us that the room is also refrigerated because the pre-preg goes off if warm.

For the most part - especially given the above blog post - I am mostly comfortable with Rolls Royce's claim that the titanium sandwich fan blade is competitive with carbon fiber blades.

Or I was comfortable before this: a video of a next-generation Rolls Royce engine (scheduled for a 2025 release…)

This is a film of a 747 flying with three standard engines and a "donor engine". The donor engine is very large and the fan blade is blue. It is blue because the blade is made of plastics.

When Luke and I went on a factory tour of Rolls Royce we asked them how they reconciled their previous statements that their titanium blades are as good as composite blades with the obvious research they were doing on composite blades.

Their answer: titanium blades are thinner than composite blades. This means that for similar aerodynamics they can be made less deep than composite blades – and this offsets the weight advantage of composite blades. This I have seen with my own eyes (sorry I do not have pictures) but the Rolls Royce blades are indeed less deep than the composite blades. This can sort of be seen in the above videos as well.

Then the clincher. The new technology will allow composite fan blades to be made as thin as titanium ones – and therefore (at least on engines larger than a corporate jet) the titanium ones will be obsolete.

It was this discussion that led us to Albany International.

Albany and LEAP engines

We know for sure that this is being used as the blade on the LEAP engine. Here is a video of the Rochester plant (see picture above)…

Note that it is a Safran plant but the signage shows it to be a JV with Albany. Moreover the video clearly shows carbon fiber being woven in an obviously complicated pattern. (Hexcel has confirmed to us that they provide the fibers to this plant.)

And here is the French Prime Minister visiting a JV plant in France. There is a similar video a year ago with the French President.

This is obviously pretty important to Safran. Again it is quite clearly a joint venture with plenty of staff in Albany uniforms.

Questions we should think about answering

What are the terms of the JV and how does Albany get paid? It seems in the press release to be an equal partnership but honestly I do not know.

C-FAN (the original composite fan blade business) is a JV between SAFRAN and GE. And only GE planes fly them. Is this a JV between Albany and SAFRAN because the JV wants to sell to parties other than GE (ie Rolls, Pratt & Whitney)?

First question: Who provided the technology for the Rolls Royce composite blade (ie the blue one in the video above).

We know a little about the Rolls fan from this press release – and it does not look like a braided/woven fan blade – which is somewhat contradictory of the argument above. In it Rolls says:

The new CTi blade is created by laying strips of carbon fibre, pre-impregnated with an epoxy resin, into a mould using a precision controlled robot. This is then cured in an autoclave by applying temperature and pressure (a bit like a very advanced pressure cooker). The moulded blade is precision machined and coated before a titanium sheath is bonded to the front edge. The finished component is inspected and measured using ultrasound and subjected to very rigorous mechanical testing

This looks a lot like the C-Fan video aboce – rather than the Albany-SAFRAN JV. Moreover the partner is GKN – the auto company that happens to make some carbon fiber components for the A350 – and that is not this sort of weaving. Those products are traditional carbon fiber laminates.

Second question: What are the opportunities for Albany for aerospace projects beyond the ones listed. [I gather for instance that it is not possible to retrofit carbon fans to old engines because because the rest of the engine is essentially paired with a fan technology…]

Third question: What are Pratt & Whitney doing re composite fan blades? I do not know but the forward order book of their geared turbofan product is pretty good. Getting the Pratt business would be nice. The GTF product probably has different forces on fan blades because the company has a gear box which slows the front fan blade down compared to the engine core.

And finally the critical question: what eventual margin can I expect for all this business. My guess is about 30 percent – which seems about right for a new tech in aerospace – but in all honesty that is a straight guess. That would be enough margin to get excited about this stock.

If we can clear all this how do we value it?

I have deleted this section. It was a little crude - and you dear reader can do that yourself.

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Now all this was a "work program" and we did plenty of work. And there are several things in this I know now to be wrong. For instance the geared turbofan has a metal fan as per this Alcoa video:

I suspect other suggestions in the work program are wrong. I am happy to be corrected. Email, phone. Please be in contact.

5 comments:

Will L
said...

Hi John,

Thanks for the post - thought it worth noting that Coats plc (from the Guinness Peat Group of old) are also talking about the composites market starting to take off. Their is a small part of their recent interims presentation dedicated to this on slide 7: http://www.coats.com/assets/files/cms/COA___HY16_presentation_28072016.pdf. They suggested it would be at a higher margin than their 'Specialty' threads which would tally with a 20% operating margin.

Re new composite blade technology - I don't know much about the aerospace tech space but from what I know about general technology adoption. The best technology usually get adopted rapidly.. Tape, CD, et al. Aerospace could be different.. But slow adopting technologies are very rare...

Haven't they said very clearly that the EBITDA margins are going to be 18-20% in AEC + Harris? Not sure where you got your 30% from ...

Q2 16 CCA - Joseph G. Morone: I think we haven't – I would say that if you start with what we said when we announced thetransaction that we thought the margins for the combined business would ramp up to 18% to 20% by the end of thedecade. We have not come off that number. I think our degree of confidence and ability to achieve that number if wesuccessfully integrate on all three levels, our degree of confidence is growing.

In many cases of potential diamonds in the rough, I like to see management clearly enjoying it's own cooking. I.e. - when the future looks great, insiders often seem to become net buyers. Like any "indicator", it is far from perfect, but I'm not seeing anything from the quick and dirty insider transactions peek on Yahoo that sparks my interest.

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